What Is Wage Continuation Pay and How Does It Work?

Wage continuation pay provides a financial safety net for individuals temporarily unable to work. It offers a portion of regular earnings during absences, helping to mitigate the financial impact of unforeseen circumstances. This compensation maintains financial stability when an individual cannot generate income through usual employment.

Defining Wage Continuation Pay

Wage continuation pay is a program that provides employees with a portion of their regular wages when they are absent from work due to specific reasons, such as illness or injury. Unlike regular wages, which are earned for services rendered, wage continuation is a payment made in lieu of earnings during a period of non-work. This distinction is important because it often influences how these payments are managed and taxed.

Payments can originate from various sources, including the employer directly, a third-party insurance provider, or state agencies. The specific terms, including the percentage of wages paid and the duration of benefits, are outlined in employer policies or benefit plans.

Common Scenarios for Wage Continuation

Wage continuation pay addresses various types of absences from work, offering financial support when an individual cannot work due to health issues or specific personal circumstances.

Short-term disability (STD)

Short-term disability (STD) is a common form of wage continuation that provides income replacement for non-work-related illnesses or injuries that temporarily prevent an employee from working. These benefits typically begin after a waiting period, often around one to two weeks, and can last for a duration ranging from a few weeks to several months, commonly up to 26 weeks. The percentage of income replaced by STD benefits varies but often falls between 50% and 70% of regular wages.

Long-term disability (LTD)

Long-term disability (LTD) provides continued income replacement when an illness or injury extends beyond the duration of short-term disability. LTD plans are designed for more severe and prolonged conditions, offering benefits for years or even until retirement age, depending on the policy terms. The waiting period for LTD typically follows the exhaustion of STD benefits, often around 90 to 180 days. LTD generally replaces a lower percentage of income than STD, commonly around 60% of pre-disability earnings.

Workers’ compensation

Workers’ compensation payments are for injuries or illnesses sustained as a direct result of work-related activities. These benefits cover medical expenses and a portion of lost wages, usually two-thirds of the individual’s average weekly wage, depending on state regulations. Employers or their insurers provide these payments. In some cases, employers may opt for “salary continuation” where they pay full wages directly instead of standard workers’ compensation benefits.

Paid sick leave and paid family leave (PFL)

Paid sick leave and paid family leave (PFL) are also forms of wage continuation, though often for shorter durations. Paid sick leave allows employees to take time off for their own illness, injury, or medical appointments, or to care for a sick family member, while still receiving their regular pay. Paid family leave, where mandated by states or offered by employers, provides paid time off for specific family-related reasons, such as caring for a new child, a seriously ill family member, or for certain military exigencies. These benefits are typically paid directly by the employer or through a state-administered program.

Tax Implications of Wage Continuation Pay

The taxability of wage continuation payments varies significantly, primarily depending on who paid the premiums for the underlying benefit. These payments can be subject to federal income tax, Social Security (FICA) tax, Medicare tax, and state income taxes.

When an employer pays 100% of the premiums for a wage continuation plan, any benefits received by the employee are generally considered taxable income. This applies to payments from short-term disability, long-term disability, and other employer-sponsored plans where the employer covers the entire cost. Such taxable payments are subject to federal income tax withholding. For Social Security and Medicare taxes (FICA), disability payments are generally subject to these taxes for the first six calendar months after the last calendar month in which the employee worked. After this six-month period, these payments are no longer subject to FICA taxes.

Conversely, if an employee pays the entire premium for a wage continuation plan with after-tax dollars, the benefits received are generally not subject to federal income tax. This is because the employee has already paid taxes on the money used to purchase the coverage. If both the employer and employee contribute to the premiums, the taxability of the benefits is prorated based on the percentage of premiums paid by each party.

Workers’ compensation benefits for personal physical injuries or sickness are generally exempt from federal income tax. This exclusion applies to payments for temporary disability, permanent disability, and death benefits. However, if workers’ compensation payments are received for lost wages and the recipient also receives Social Security Disability Insurance (SSDI) benefits, a portion of the workers’ compensation may become taxable if it reduces the SSDI benefits. State income tax treatment of wage continuation pay generally follows federal guidelines, but specific state laws may have unique rules regarding taxability, so it is important to check state tax regulations.

Reporting Requirements for Wage Continuation Pay

Reporting wage continuation payments to the Internal Revenue Service (IRS) involves specific forms, depending on the payer and the nature of the benefits. These forms ensure accurate records for both the recipient and the IRS.

When an employer or an agent of the employer, such as a third-party sick pay administrator, makes wage continuation payments, these amounts are reported on Form W-2, Wage and Tax Statement. Taxable sick pay is usually included in Box 1 (Wages, tips, other compensation), and any federal income tax withheld is shown in Box 2. For payments subject to Social Security and Medicare taxes, these amounts are reported in Boxes 3 and 5, respectively, with corresponding tax withholdings in Boxes 4 and 6.

For wage continuation payments made by non-employer entities, such as some disability insurers or state agencies, especially if the payments are taxable, they are often reported on Form 1099-MISC, Miscellaneous Income, or Form 1099-NEC, Nonemployee Compensation. Payments for disability benefits that are taxable may appear in Box 3 of Form 1099-MISC, labeled “Other income.” If the payments are considered nonemployee compensation, they would be reported in Box 1 of Form 1099-NEC. The entity responsible for issuing the payments is also responsible for issuing the appropriate tax form to the recipient and the IRS.